The Case Against Raj Rajaratnam Is A Huge Waste Of Time

We've long been on the
record as skeptics of insider trading enforcement. The case
against Raj Rajaratnam has revived all our doubts.

Some of the charges seem like criminalizing the game of telephone
that makes up a lot of the information gathering by traders. The
charges depend on extensions of legal doctrines that were already
far adrift from the actual statutory and regulatory basis on
which they were built.

Just look at the charges about Google: the Accused Trader heard
from Person A who heard from Investor Relations Tipper who heard
from Google Insider that earnings would be poor. At some stage,
you have to wonder when in a long train of information that taint
of illicit breach of confidentiality just washes off. What's
more, when someone in that chain--we forget who because there are
just too many links--demanded money, they were turned down. This
wasn't some nefarious plot using cut-outs and black bags full of
cash.

The federal government appears to be in some sort of financial
panic. It is using the kind of tactics developed to fight
mobsters and terrorists to detect violations of something called
Rule 10b-5. But mobsters and terrorists have genuine victims,
often easily detectable by their corpses. Who is the victim of
insider trading? It is some theoretical person who may not have
traded if he had the same information as the alleged insider
trader. But markets are dominated by asymmetric information, so
this is pure nonsense.

Fortunately, some are offering a more sober view of insider
trading. In the weekend edition of the Wall Street Journal,
Donald J. Boudreaux argues that "Federal agents are wasting
their time slapping handcuffs on hedge fund traders like Raj
Rajaratnam."

"Insider trading is impossible to police and helpful to markets
and investors," Boudreaux argues.

Here's a summary of his major arguments against criminalizing
insider trading.

Outsiders benefit from insider trading. When
insiders sell stocks because they know bad news is coming, the
price of the stock reflects that selling. This helps prevent
outsiders from buying stocks at prices inflated because of
corporate secrecy.

Avoiding insider trading in inefficient.
When a trader gets hold of insider information from a tainted
source, the law says he should avoid trading. In other words,
Rajaratnam should have told his traders he wasn't allowed to
influence their trades because he knew too much. This means
prices will adjust more slowly to the information in the
market.

Malinvestment hurts the entire economy. During
the time while prices are lying about the health of a company,
the market will divert lots of resources in its direction.
Investors will provide capital and creditors will lend money.
Healthier companies will find it more difficult to raise
capital or borrow. Money that could be better spent, will be
wasted. In short, the ban on insider trading damages the entire
economy.

Investors worried about insider trading will
diversify. Perhaps the costliest mistake an investor
can make is to believe that he or she can time the market and
pick stocks. This problem is made worse when investors have a
false confidence that the market is a level playing field.
Investors fearful of insider trading in individual stocks will
be more likely to diversify their investments so that they can
benefit from the insider trading instead of losing out to it.

There's no way to police insider non-trading.
Inside information doesn't always lead to buying stocks.
Sometimes inside information on stocks leads to the conclusion
that a stock should not be bought. If Rajaratnam had used the
tip from Roomy Khan to avoid buying Google, rather than
actually shorting it or selling options, he would have
committed no crimes. But this kind of insider non-trading is
undetectable and no one argues that they "harm the markets."

Rather than a single national policy on insider trading, these
matters are best left to individual companies and private
litigation. Each public company should be free to set the level
and type of insider trading it will allow, and pursue employees
who violate those policies through private, civil litigation.
Since there is no genuine public harm involved, there should be
no governmental enforcement.